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The following article is part of an ongoing educational series. The previous article can be found here.

By this point in our ongoing educational series, it should be clear that the dividend a company pays bears a close relationship to its future share price, and therefore its ability to make a capital gain for you.

But the precise nature of that relationship may still be somewhat murky. Let's set about making it clearer.

Dividends, asset value and cash flow

The dizzy three-way relationship between dividends, asset value and cash flow is almost exactly mirrored in the mandatory financial statements contained in each company's annual report.

The profit & loss statement (P&L) tells you the company's earnings for the year, or at least the accounting treatment of the earnings.

The balance sheet provides a year-end snapshot of all the company's assets and liabilities and the ownership stake of the shareholders.

The cash flow statement gives you an idea of the money the company is generating from operating its core businesses, as opposed to, say, paper profits from the revaluation of assets and other variations.

Whenever a company earns a profit, its directors have two options (actually, they have dozens, one of which includes a more generous remuneration scheme for directors, but we're interested in just two for now):

1. They can hold on to that profit as retained earnings and plough it back in to the business to fund future growth, or

2. They can pay out the profit to shareholders as dividends.

The actual amount of the dividend payment is not calculated by any particular accounting formula - it is simply an arbitrary decision on behalf of the directors to allocate profits to shareholders.

This means that, although the dividend you receive from a company comes out of its earnings, it does not necessarily reflect those earnings.